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It has been very hectic for me recently with a lot of personal and professional changes. So while we are at it here is another change – I will in the future from time to time try to post commentary in a bit of a different format – I will be talking to my phone. Have a look at my first attempt of phone-blogging here (I recorded it Friday night.)

I would love to hear your comments on this and don’t worry – I will continue to do regular blogging. In fact I expect to blog at a higher frequency in the future.

Today I talked to an Israeli friend about the state of the Israeli economy and particularly about the importance of monetary policy. One can really characterise the Israeli economy as being ‘boring’ in the sense that growth, inflation and markets have been quite stable in recent years – despite of the “normal” political (and geopolitical) uncertainty in Israel.

My friend told me a very interesting anecdote, which in my view quite well explains why things have been so ‘boring’ in Israel in recent years. He told me that in 2007 as the first financial jitters had hit the global economy Bank of Israel (BoI) governor Stanley Fischer had explained what was going to happen.

According to my friend Stan Fischer said two things. First, Fischer had warned that what was underway in the global financial markets and the global economy would become very bad. In that sense Fischer rightly ‘predicted’ the crisis. Second, and more importantly in my view Fischer had demonstrated just how well he understand monetary theory and policy. Hence, my friend had asked how it would be possible to offset an external (demand) shock to the Israel if interest rates would drop to zero.

Fischer had explained that there would be no problem at the Zero Lower Bound. The BoI would always be able to ease monetary policy – even if interest rates were stuck at zero. And Fischer then went on to explain how you could do quantitative easing and/or intervene in the currency market.

It should of course be noted that this account is second-hand and my friend might have not gotten everything exactly right from something Fischer said five years ago. However, subsequent events actual tend to show that Fischer was not only well-prepared for the crisis, but also knew exactly what to do when crisis hit. This can hardly be said for European and US central bankers who in general completely failed to do the right thing in 2008.

And note here that I am not praising anybody for acting in a discretionary fashion. What I am praising Fischer for is that he fully well understood that the “liquidity trap” only is a mental constraint in the heads of central bankers (Just listen here to Fischer explaining this on Bloomberg TV back in 2010 when the Fed had announced QE2 – he is also bashing those central bankers who complain about ‘currency war’).

And Fischer did exactly what he had said could be done if necessary when it in fact became necessary in 2009 to ensure nominal stability. Hence, in February 2009 the BoI started to conducted quantitative easing. The graph below illustrates Fischer’s remarkable success.

That is a straight line if you ever saw one! And there was no dip in NGDP in 2008 or 2009. Just straight on. Israel never had a Great Recession.

While Stan Fischer in recent years has voiced some scepticism about nominal GDP targeting and instead praised flexible inflation targeting, looking at the data actually shows that the Bank of Israel under his leadership from 2005 to 2013 effectively had a NGDP target. And it is also clear that Fischer quite openly pointed out – particularly in 2009 – that he would not mind temporarily overshooting on the BoI’s official inflation target if the increased inflation was driven by a negative supply shock (depreciation of the Israeli shekel).

I believe that Fischer’s de facto NGDP targeting rule is exactly what has ensured a very high level of nominal stability in the Israeli economy over the past decade. This is a remarkable result given the very sizeable negative shock in 2008-9 and the ever present political and geopolitical shocks to the Israel economy and markets.

Another very important element in my view is that the BoI under Fischer’s leadership has been tremendously forward-looking compared to other central banks in the world. Hence, it is very clear that the BoI has been focused on targeting the forecast rather than targeting present inflation (in the way for example the ECB is doing). Just read nearly any statement from the Bank of Israel. There will nearly always be an reference not only to inflation expectations, but to market inflation expectations. In that sense the BoI is doing exactly what Market Monetarists have been arguing central banks should – use the market to ‘predict’ the outlook for nominal variables whether inflation or nominal GDP.

Furthermore, as market participants realise that the BoI is effectively targeting the (market) forecast the market will do a lot of the implementation of monetary policy. Hence, if market expectations of inflation is too high (low) compared to the BoI’s official inflation target then the market will expect the BoI to tighten (ease) monetary policy. That causes investors to buy (sell) shekel on the expectation of future appreciation (depreciation) as the BoI is expected to move toward monetary tightening (easing). This is of course what I have called the Chuck Norris effect of monetary policy. Under a credible monetary policy regime the markets will more or less “automatically” implement monetary policy to ensure that the monetary policy target is hit – all the central bank has to do is to clearly define its target and to follow the lead from the market.

Can other central bankers do the same as Fischer?

The economic development in Israel over the past decade is surely remarkable. Few – if any – other countries have achieved anything close to what Stanley Fischer ensured in Israel. The question of course is whether other countries can do the same thing.

Surely I would be the first to acknowledge that luck (and unlock) is important for the success of central bankers. However, I believe that central bankers can indeed copy the success of Fischer by sticking to four general principles:

1) There is no liquidity trap if you just use other instruments to ease monetary policy than the interest rate (in fact central banks should completely stop communicating about the monetary policy in terms of interest rates).

2) Target the forecast. Central banks should not be backward-looking. Instead central banks should follow the example of Fisher’s BoI and focus on the expected future inflation or the level of NGDP rather than looking at present or paste inflation/NGDP level.

3) Let the markets do most of the lifting. By clearly targeting the forecast the market can effectively do most of the actual implementation of monetary policy – and the central bank should encourage this.

4) Be clear on the target. To allow the markets to implement monetary policy the central bank needs to be completely clear about what the central bank actually wants to achieve. And this is probably where I think Fischer did worst during his years at the BoI. It is clear that he de facto was targeting NGDP rather than inflation, but he has never publically acknowledged this.

Luckily Stan Fischer is not retired. Instead he has moved on to become vice-Chairman at the Federal Reserve. If we are lucky he will help Fed boss Janet Yellen do the the right thing on monetary policy and if the US can achieve the same kind of nominal stability as Israel did during Fischer’s term as BoI governor then the outlook for the global economy is quite rosy.

The rally in the global stock markets has clearly run into trouble in the last couple of weeks. Particularly the Nikkei has taken a beating, but also the US stock market has been under some pressure.

If one follows the financial media on a daily basis it is very clear that there is basically only one reason being mentioned for the decline in global stock markets – the possible scaling back of the Federal Reserve’s quantitative easing.

“Stocks posted sharp declines across the board Wednesday, with the Dow ending below 15,000, following weakness in overseas markets and amid concerns over when the Fed will start tapering its bond-buying program on the heels of several mixed economic reports.”

“Fear that the central bank may start scaling back its $85 billion in monthly bond purchases has helped trigger a sharp increase in market volatility over the last couple of weeks both here and overseas.”

I believe that what we are seeing in the financial markets right now is telling us a lot about how the monetary transmission mechanism works. Market Monetarists say that money matters and markets matter. The point is that the markets are telling us a lot about the expectations for future monetary policy. This is of course also why Scott Sumner likes to say that monetary policy works with long and variable LEADS.

Hence, what we are seeing now is that US monetary conditions are being tightened even before the fed has scaled back asset purchases. What is at work is the Chuck Norris effect. It is the threat of “tapering” that causes US stock markets to decline. Said in another way Ben Bernanke has over the past two weeks effectively tightened monetary conditions. I am not sure that that was Bernanke’s intension, but that has nonetheless been the consequence of his (badly timed) communication.

This is also telling us that Market Monetarists are right when we say that both interest rates and money supply data are unreliable indicators of monetary conditions – at least when they are used on their own. Market indicators are much better indicators of monetary conditions.

Hence, when the US stock market drops, the dollar strengthens and implied market expectations of inflation decline it is a very clear signal that US monetary conditions are becoming tighter. And this is of course exactly what have happened over the last couple of weeks – ever since Bernanke started to talk about “tapering”. The Bernanke triggered the tightening, but the markets are implementing the tigthening.

Leave it to the market to decide when the we should have “tapering”

I think it is pretty fair to say that Market Monetarists are not happy about what we are seeing playing out at the moment in the US markets or the global markets for that matter. The reason is that we are now effectively getting monetary tightening. This is certainly premature monetary tightening – unemployment is still significantly above the fed’s unofficial 6.5% “target”, inflation is well-below the fed’s other unofficial target – 2% inflation – and NGDP growth and the level NGDP is massively below where we would like to see it.

It is therefore hardly the market’s perception of where the economy is relative to the fed’s targets that now leads markets to price in monetary tightening, but rather it is Bernanke’s message of possible “tapering” of assets purchases, which has caused the market reaction.

This I believe this very well illustrates three problems with the way the fed conducts monetary policy.

First of all, there is considerable uncertainty about what the fed is actually trying to target. We have an general idea that the fed probably in some form is following an Evans rule – wanting to continue to expand the money base at a given speed as long as US unemployment is above 6.5% and PCE core inflation is below 3%. But we are certainly not sure about that as the fed has never directly formulated its target.

Second, it is clear that the fed has a clear instrument preference – the fed is uncomfortable with conducting monetary policy by changing the growth rate of the money base and would prefer to return to a world where the primary monetary policy instrument is the fed funds target rate. This means that the fed is tempted to start “tapering” even before we are certain that the fed will succeed in hitting its target(s). Said, in another way the monetary policy instrument is both on the left hand and the right hand side of the fed’s reaction function. By the way this is exactly what Brad DeLong has suggested is the case. Brad at the same time argues that that means that the fiscal multiplier is positive. See my discussion of that here.

Third the fed’s policy remains extremely discretionary rather than being rule based. Hence, Bernanke’s sudden talk of “tapering” was a major surprise to the financial markets. This would not have been the case had the fed formulated a clear nominal target and explained its “reaction function” to markets.

Market Montarists of course has the solution to these problems. First of all the fed should clearly formulate a clear nominal target. We obviously would prefer an NGDP level target, but nearly any nominal target – inflation targeting, price level targeting or NGDP growth targeting – would be preferable to the present “target uncertainty”.

Second, the fed should leave it to the market to decide on when monetary policy should be tightened (or eased) and leave it to the market to actually implement monetary policy. In the “perfect world” the fed would target a given price for an NGDP-linked bond so the implied market expectation for future NGDP was in line with the targeted level of NGDP.

Less can, however, do it – the fed could simply leave forecasting to either the markets (policy futures and other forms of prediction markets) or it could conduct surveys of professional forecasters and make it clear that it will target these forecasts. This is Lars E. O. Svensson’s suggestion for “targeting the forecast” (with a Market Monetarist twist).

Concluding, the heightened volatility we have seen in the US stocks markets over the last two weeks is mostly the result of monetary policy failure – a failure to formulate a clear target, a failure to be clear on the policy instrument and a failure of making it clear how to implement monetary policy.

Bernanke don’t have to order the printing of more money. We don’t need more or less QE. What is needed is that Bernanke finally tells us what he is really targeting and then he should leave it to the market to implement monetary policy to hit that target.

The graph below shows the ratio of upward to downward revisions of equity analysts’ earnings forecasts in different countries. I stole the graph from Walter Kurtz at Sober Look. Walter himself got the data from Merrill Lynch.

Just take a look in the spike in upward earnings revisions (relative to downward revision) for Japanese companies after Haruhiko Kuroda was nominated for new Bank of Japan governor back in February and he later announced his aggressive plan for hitting the newly introduced 2% inflation target.

This is yet another very strong prove that monetary policy can be extremely powerful. The graph also shows the importance of the Chuck Norris effect – monetary policy is to a large extent about expectations or as Scott Sumner would say: Monetary Policy works with long and variable leads – or rather I believe that the leads are not very long and not very variable if the central bank gets the communication right and I believe that the BoJ is getting the communication just right so you are seeing a fairly strong and nearly imitate impact of the announced monetary easing.

PS As there tend to be a quite strong positive correlation between earning growth and nominal GDP growth I think we can safely say that the sharp increase in earnings expectations in Japan to a large extent reflects a marked upward shift in NGDP growth expectations.

This is what Bernanke could (or rather should) say about Italian events:

“Let me remind everybody that we have the instruments to shield the US economy from negative spill-over from political and financial events in Europe. We have said that we want to stabilize nominal spending in the US and if events in Europe jeopardize the fulfillment of our targets then we will increase money base growth to counteract these shocks. However, I do not expect that to be necessary as the markets should be well aware of our intentions to stabilize nominal spending and I therefore expect markets to adjust appropriately to do the job for us”

You can replace “stabilize nominal spending” with whatever nominal target you like.

I continue to be completely puzzled that somebody would think that central banks somehow have run out of ammunition and that monetary policy is impotent. The developments in the global financial markets since August-September last year clearly tell you that monetary policy is extremely potent – also when interest rates are at the Zero Lower Bound.

Japanese shares rose, with the Nikkei 225 Stock Average heading for the highest close since September 2008, as the yen fell after Bank of Japan Governor Masaaki Shirakawa said he will step down ahead of schedule.

…The Nikkei 225 gained 3 percent to 11,377.53 as of 12:38 p.m. in Tokyo, heading for the highest close since Sept. 29, 2008, two weeks after the collapse of Lehman Brothers Holdings Inc. Volume today was 48 percent above the 30-day average. The broader Topix Index advanced 2.8 percent to 966.03, with eight stocks rising for each that fell.

…The Topix has surged 34 percent since elections were announced on Nov. 14 on optimism a new government will push for aggressive stimulus. The gauge is trading at 1.14 times book value, compared with 2.1 for the Standard & Poor’s 500 Index and 1.45 for the Stoxx Europe 600 Index.

The yen slid to its weakest level in almost three years against the dollar and euro on speculation Japan’s government will hasten the selection of a new central bank chief to take further steps to end deflation.

Japan’s currency added to yesterday’s biggest drop versus the euro in more than a week after Bank of Japan Governor Masaaki Shirakawa said he will step down on March 19, almost three weeks before his term is due to end. Demand for the 17- nation euro was supported on prospects the European Central Bank will refrain from easing monetary policy tomorrow. The Australian dollar slid after data showed the nation’s retail sales unexpectedly fell in December.

Financial markets are the best indicators of the monetary policy stance we have – a surging Japanese stock market and much weaker yen is a very strong indication that Japanese monetary conditions are getting decisively easier. Easier monetary conditions mean higher Japanese nominal GDP – just wait and see.

The market action in the Japanese markets this morning is yet another extremely clear demonstration of the Chuck Norris effect – that monetary policy does not only work through “printing money”, but also through expectations. As Scott Sumner likes to say – monetary policy works with long and variable leads. Said in another way a new Bank of Japan governor has not even been appointed but he is already easing monetary conditions in Japan as Mark Carney is in the UK.

And to all you Keynesian fiscalists out there I challenge you to find me one single example of “optimism” about “fiscal stimulus” having moved any major stock market by 4% in a day!

What we are seeing now in the US, Japan and likely soon in the UK is the kind of Rooseveltian Resolve that brought the US economy out of the Great Depression in 1933 after Roosevelt went off the gold standard and trust me – monetary policy does work! In the 1930s the “gold bloc” countries failed to understand that – today it is the ECB – but luckily for Europeans the US and Japan are leading the charge and is pulling us out of this crisis. That is what the global stock markets have been celebrating since August-September. It is really simple.

These days we are getting a proper illustration of the Chuck Norris effect – that the central bank can ease monetary policy through sheer credibility without even printing more money. In fact in the case of Mark Carney he is now easing monetary policy in the UK even before he has become Bank of England governor. That is pretty impressive, but also good news for the UK economy. It is of course the expectation that Mark Carney as coming BoE governor will be in charge of introducing some form of NGDP level targeting.

“U.K. inflation expectations rose to the highest level in 21 months amid speculation Mark Carney will expand monetary policy and spur price rises when he takes over as Bank of England governor in July.

The so-called break-even rate increased for a fifth day before Carney testifies to U.K. lawmakers this week after telling the World Economic Forum’s annual meeting in Davos, Switzerland, last month that policy in developed countries isn’t “maxed out.” Ten-year bonds fell after an industry report showed U.K. services expanded in January, undermining demand for fixed-income assets. The pound weakened against the euro.”

Market expectations of inflation in my view are one of the best measures of changes in the monetary policy stance. When inflation expectations are inching up it is a very clear indication that monetary conditions are getting easier. That is what is happening in the UK at the moment.

Central banks essentially have two monetary policy instruments. First of all they can print money – increase the money base. Second they can guide expectations. The latter is often much more important and that is exactly what we are seeing in the UK markets these days.

Effectively Mark Carney is already in charge of UK monetary policy – the only thing he has to do is hint what he would like to see happen with UK monetary policy going forward.

Here is ft.com quoting John Williams president of the Federal Reserve Bank of San Francisco:

“If the Fed launched another round of quantitative easing, Mr Williams suggested that buying mortgage-backed securities rather than Treasuries would have a stronger effect on financial conditions. “There’s a lot more you can buy without interfering with market function and you maybe get a little more bang for the buck,” he said.

He added that there would also be benefits in having an open-ended programme of QE, where the ultimate amount of purchases was not fixed in advance like the $600bn “QE2” programme launched in November 2010 but rather adjusted according to economic conditions.

“The main benefit from my point of view is it will get the markets to stop focusing on the terminal date [when a programme of purchases ends] and also focusing on, ‘Oh, are they going to do QE3?’” he said. Instead, markets would adjust their expectation of Fed purchases as economic conditions changed.”

Williams is talking about open-ended QE. This is exactly what Market Monetarists have been recommending. The Fed needs to focus on the target and not on how much QE to do to achieve a given target. Let the market do the lifting – we call it the Chuck Norris effect!

I don’t particularly feel an obligation to comment on today’s ECB monetary policy announcement and I think my regular readers have a pretty good idea about how I feel about the ECB these days. However, ECB chief Mario Draghi pulled out a traditional ECB phrase on the outlook on monetary policy that I think pretty well describes the ECB’s problem and why we are in mess we are in.

Mario Draghi said – as Trichet used to before him – that “we never pre-commit” to any particular future monetary policy action. My reply to Draghi would be isn’t that exactly your problem!?

Yesterday, I did a post on the importance of the expectational channel in monetary policy and how the Chuck Norris effect or what Matt O’Brien has called the Jedi mind trick can be a tremendous help in the conduct of monetary policy. If you have a credible target and credible reaction function the markets are likely to do most of the lifting in terms of monetary policy implementation. However, when Draghi is saying that the ECB is not pre-committed on monetary policy then he is effectively saying “We don’t want to tell you what your target is and we are not going to reveal our reaction function”. That of course means that the ECB will get no help from Chuck Norris (the markets) to implement policy.

On the other hand if Draghi had said “The ECB is pre-committed to use whatever instruments in our arsenal to achieve our nominal targets and will do unlimited amounts of buy or selling of assets to achieve these targets” then Draghi would not have to do much more. Chuck Norris would help him so he could spend more time golfing.

However, you get the feeling that the ECB on purpose wants to be ambiguous on what monetary policy action it will take and what it want to target. From a monetary policy perspective this makes no sense at all. Why would a central bank do something like that? What monetary theory is telling the ECB that it is a good idea not to pre-commit? I think the answer is nothing to do with monetary theory and everything to do with public choice theory. The special ECB lingo like “we never pre-commit” seem to be designed to ensure the legitimacy of the ECB. The lingo is simply rituals that should convince us that the ECB is a legitimate institution and it’s powers should not be questioned. See more on this topic here.